One year ago, a pocket of borrowed money on the edge of UK bond markets imploded, which had significant consequences and led to the Bank of England’s intervention. Now, the world’s most influential regulators are increasing their scrutiny of a similar potential risk in the $25tn US government bond market.
The Bank for International Settlements and the US Federal Reserve have both highlighted the rapid increase in hedge fund bets in the Treasury market. This basis trade involves playing two similar debt prices against each other using borrowed money to profit from the small gap between them. While different from the UK’s investment meltdown, the use of heavy leverage and sudden market movements make this strategy potentially problematic.
The exact scale of the basis trade is hard to determine, but leveraged funds’ short positions in liquid futures contracts reached a record high of almost $900bn in late August. The Federal Reserve has warned that this strategy poses a “financial stability vulnerability,” and the Bank for International Settlements has stated that it could disrupt trading.
The US Treasury market is crucial to the global financial system as the yield on federal government debt serves as the risk-free rate for all asset classes. The UK market crisis last year demonstrated how quickly disorder can occur when leverage is involved, a concern for regulators given the accumulation of potential problems during a period of low interest rates.
Some argue that the Federal Reserve’s interventions in the Treasury market have created moral hazard, as speculation is implicitly backed by the central bank’s willingness to stabilize the market. However, hedge funds argue that they provide vital liquidity and contribute to the efficient functioning of the market.
Hedge funds have taken on an increasingly important role in the Treasury market, as primary dealers have pulled back since the financial crisis due to increased costs. Hedge funds and high-speed traders, less regulated than banks, now play a significant role in buying bonds and making prices for other investors, including through the basis trade.
The basis trade has become more popular this year as the Federal Reserve’s interest rate hikes and the growing size of the Treasury market have pushed yields higher. This has led to increased demand in the futures market from asset managers looking to secure returns. Hedge funds exploit the price gap between Treasury futures and cash bonds, using borrowed money to magnify their bets.
However, central banks and regulators are concerned that any dislocation in the market could quickly escalate into broader issues. The Fed has identified stress on the basis trade as a factor in the downturn in Treasury prices during the Covid-19 pandemic and a seize-up in the repo market in 2019.
There are several risks associated with the basis trade, including banks cutting back on leverage or increasing the cost of short-term lending during market stress. Clearing houses can also require more collateral against trading positions, as seen during the collapse of Silicon Valley Bank. A move in repo rates can also impact the amounts banks are willing to lend against hedge fund trades.
Regulators warn that a few large firms unwinding their bets could trigger a domino effect, causing distressed selling in the Treasury market and potentially leading to a liquidity crisis.
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